The Effect of Internal Control on Corporate Corruption: Evidence from China

Transcription

1 The Effect of Internal Control on Corporate Corruption: Evidence from China Weili Ge Michael G. Foster School of Business University of Washington Seattle, WA Zining Li Cox School of Business Southern Methodist University Dallas, TX Qiliang Liu School of Management Huazhong University of Science and Technology Wuhan, China, Sarah McVay Michael G. Foster School of Business University of Washington Seattle, WA November 4, 2014 Ge and McVay would like to thank the Moss Adams Professorship and Glen & Lucille Legoe Professorship, respectively, at the University of Washington for financial support. Liu acknowledges the financial support from the National Natural Science Foundation of China (Project No and ). We thank workshop participants at the University of Missouri at Columbia for helpful comments. We thank Professor Hanwen Chen and his team for sharing the internal control index data developed under National Natural Science Foundation of China Project Nos

2 The Effect of Internal Control on Corporate Corruption: Evidence from China Abstract We examine whether internal control over financial reporting reduces the extent of corporate corruption (a form of corporate abuse in which controlling shareholders or managers expropriate resources from the firm). Using a sample of Chinese-listed firms, we find that after controlling for known determinants of corruption and internal control, firms with strong internal controls are significantly less likely to extract resources from the firm (either in the form of loans, reimbursement of personal consumption expenses, or receipt of bribes). We find this relation is concentrated within non-state-owned firms, providing some evidence of the need to establish substance over form when assessing the strength of internal control. Taken together, our results suggest that, on average, strong internal controls curb corporate corruption; however, institutional factors and the associated incentives play a significant role in the effectiveness of internal controls. Keywords: Internal control over financial reporting; corporate corruption; state-owned enterprises

3 1. Introduction We examine the relation between the strength of internal control and corporate corruption. We define corporate corruption as a form of corporate abuse in which controlling shareholders or managers expropriate resources from the firm and thereby minority shareholders. 1 For example, CEOs are often persuaded through bribes to contract with inferior suppliers offering higher-priced or lower-quality inventories relative to other suppliers. CEOs can also transfer funds to related parties as loans with indefinite loan terms. Another common tactic for managers to tunnel cash from the firm is through the reimbursement for their personal consumption expenses. Although corruption within China has been well-documented (e.g., Jiang et al., 2010; Cai et al., 2011; Piotroski and Wong, 2012), our interest is in whether internal controls can effectively combat this type of corruption. The value of internal control is of considerable interest to academics, regulators and practitioners. 2 Studies using internal control disclosures of U.S. firms have generally concluded that stronger internal controls result in higher earnings quality (Doyle et al., 2007), more accurate management forecasts (Feng et al., 2009), better investment decisions (Cheng et al., 2013), and higher operating efficiency (Feng et al., 2015). There is more limited 1 The corporate corruption we investigate is related to government corruption, given China s unique institutional environment. Shleifer and Vishny (1993) define government corruption as the sale by government officials of government property for personal gain. Over half of Chinese publicly traded firms are state-owned companies (often termed as stated-owned enterprises, SOEs), meaning that the government is the controlling shareholder. As a result, the government appoints CEOs of stated owned companies, who usually are current or former government bureaucrats. 2 Following the Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework (2013), we define internal control as a process, effected by an entity s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance. The focus of this paper is on internal control over financial reporting, but in our additional analyses, we also provide evidence on internal controls that are not related to financial reporting. 1

4 evidence, however, on whether internal controls reduce self-dealing behavior. Although there is some evidence in Skaife et al. (2013) that managers benefit from ineffective controls via the profitability of their personal trades, Ashbaugh-Skaife et al. (2008) document that internal control weaknesses are more likely to lead to unintentional errors than intentional misstatements. The escalation to corruption has not been examined, although this type of selfdealing behavior is likely to be far more costly to shareholders. China is well-suited as a setting to examine the effect of internal control strength on corporate corruption for several reasons. First, within China, corruption is common and measurable. In particular, because the legal system offers only weak protection for minority investors, corporate abuse by controlling shareholders and managers is wide-spread and rather severe (Jiang et al., 2010) and there is a high risk of controlling shareholders expropriating resources from minority investors (Djankov et al., 2008). Thus, although it is difficult to measure corporate corruption within U.S. firms, we are able to measure corruption relatively reliably in China using several well-documented forms of corruption used by managers of Chinese firms. Specifically, we focus on tunneling (i.e., the use of intercorporate loans by controlling shareholders; Jiang et al., 2010), high travel and entertainment costs (Cai et al., 2011), and publicly disclosed corruption cases. Second, required disclosures in China allow for a continuous measure of internal control strength. 3 This allows for greater granularity than analyses using U.S. data, where only the small subset of firms with 3 We use a proprietary database that tracks listed Chinese firms internal control information from financial statements, filings to China Securities Regulatory Commission, government documents, and press releases (Chen et al., 2013). The database covers 99 percent of all Chinese public firms from 2007 through 2010 and allows us to measure the strength of internal control within the COSO framework. 2

5 ineffective internal controls provide granularity on their underlying problems. 4 This also allows us to distinguish between the existence of internal controls, and the effectiveness of internal controls. In particular, in the U.S., if managers override existing internal controls, the firm must disclose ineffective internal controls. In contrast, in China we can assess the existence of internal controls separately from the effectiveness of internal controls (i.e., form versus substance). We hypothesize that firms with stronger internal controls have a lower risk of corporate corruption as a stricter control and monitoring environment would make it more difficult for top management to engage in brazen activities that are harmful to minority shareholders. For example, the separation of duties in the accounting department and controls for authorizing and approving material matters would reduce the likelihood of removing cash from corporate accounts for managers personal use. We do acknowledge, however, that we might not find an association between internal control strength and corruption. In particular, the effectiveness of internal controls would be compromised if managers are able to ignore the internal control procedures, overriding them at will. In this case, the internal control system is merely window dressing. We study a sample of 4,775 firm-year observations of Chinese firms listed on the Shanghai Stock Exchange and on the Shenzhen Stock Exchange from 2007 through We first pare down the 144 items used in Chen et al. (2013) to focus on internal controls over financial reporting (69 items). We next provide evidence on the validity of our measure of 4 For example, only 7.2% of firm-year observations disclose ineffective internal controls in the U.S. sample examined in Feng et al. (2015). The other 92.8% simply disclose they maintain effective internal controls, whereas our entire population exhibits variation in ICFR strength. 3

6 internal control strength by confirming that firms with higher internal control scores exhibit less earnings management, measured by the absolute value of discretionary accruals and the incidence of financial statement restatements. This finding is consistent with that of Chen et al. (2013) using the broader measure. Following prior literature, we then measure corporate corruption in the following ways: other accounts receivable scaled by total assets to capture the use of inter-corporate loans by controlling shareholders (Jiang et al., 2010), travel and entertainment costs scaled by sales to capture the expenses incurred for managers personal benefits (e.g., eating, drinking, sports club membership, and travel; Cai et al., 2011), and public disclosures of corruption by top management. 5 We find that, after controlling for known determinants of corruption and internal control strength, firms with strong internal controls appear to tunnel fewer resources out of firm and report lower travel and entertainment expenses, consistent with our prediction that internal controls mitigate corporate corruption. We do not, however, find a significant association between internal control strength and the frequency of disclosed corruption for our full sample. Next we examine whether the relation between internal control strength and corporate corruption varies with whether the internal controls were more likely to be voluntarily adopted or policy driven, proxied by state ownership structure. An important ownership characteristic of China s listed firms is state ownership, where the government is the controlling shareholder and appoints the top management team. State-owned enterprises (SOE) comprise more than half of all firms listed on China s stock exchanges (Piotroski et al., 5 Note that we remove the corruption cases in which managers bribe government officials to earn benefits for the firm to buy protection against government expropriation or buy government services (e.g., provide permits and licenses). We focus on corrupt behavior by management that is at the expense of minority shareholders. 4

7 2014). Managers of state-owned enterprises tend to be former government officials who face multiple and potentially conflicting objectives (e.g., political incentives versus incentives to maximize minority shareholder welfare). In 2006, in an effort to reform state-owned enterprises, the Chinese government issued numerous guidelines to underscore the importance of internal controls for listed firms and applied a great deal of pressure on statedowned firms to follow the guidelines in establishing specific internal control policies and procedures. It is likely that internal control procedures adopted by state-owned firms are policy driven in that state-owned firms adopt in name a boilerplate list of internal control procedures simply to satisfy government regulators but not actually implement or enforce these internal control procedures. This institutional difference could potentially allow us to examine differences in substance versus form, as the strength of internal controls within state-owned enterprises could have a smaller effect on the risk of corporate corruption than the strength of internal controls within non-state-owned firms. We thus investigate whether these policy-driven changes in internal control guidelines and procedures are effective in reducing corporate corruption. Consistent with at least some window dressing (i.e., form over substance), we find that for our measures of tunneling and private consumption, internal control strength is less effective at curbing corporate corruption for state-owned enterprises relative to non-stateowned firms. In addition, we find a significantly negative association between internal control strength and the frequency of disclosed corruption within non-state-owned firms, but not state-owned firms. 5

8 We conclude our analysis with two additional tests. First, we employ two-stage leastsquares (2SLS) estimation procedures to address the concern that the internal control procedures are chosen and implemented by management. We continue to find that internal control strength is negatively associated with the risk of corporate corruption and this association is significantly weaker within state-owned enterprises. Second, we examine whether internal control strength is associated with the likelihood of CEOs receiving promotions (being appointed to become either a higher-ranking government official or a CEO of a larger public company). We find that within state-owned firms, CEOs of firms with higher internal control scores are more likely to be promoted, but this is not the case within non-state-owned firms. This finding corroborates our earlier results suggesting that the multidimensional incentives of CEOs at state-owned firms likely contribute to less effective internal controls (form over substance). Our findings make several contributions to the literature. First, we document the link between internal controls and corporate corruption, which has not been documented to date. The internal control disclosure requirements of the Sarbanes Oxley Act in the U.S. have triggered reforms of internal control disclosure requirements as well as other corporate governance practices in many other countries. Our findings suggest that internal control disclosures could be particularly important in emerging markets, where ownership structure is highly concentrated and legal mechanisms to curb corporate abuse are largely absent. Second, our results highlight that internal controls are significantly less effective in curbing corporate corruption within state-owned enterprises. This suggests that institutional factors and the 6

9 associated incentives play a significant role in the effectiveness of internal controls. Benefits to firms are limited when internal control systems are undermined by management. 2. Background and predictions Internal control over financial reporting is comprised of the processes and procedures established by management to maintain records that accurately reflect the firm s transactions (Deloitte and Touche 2004). 6 Effective on November 15, 2004 for accelerated filers, Section 404 of SOX requires companies to disclose management s assessment of the effectiveness of the internal control structure and procedures in the annual report and the firm s auditor must attest to this assessment. Following the implementation of Section 404, researchers have examined various benefits of effective internal controls. Prior research has shown that higher internal control strength reduces the unintentional errors in financial reporting (Ashbaugh- Skaife et al., 2008; Doyle et al., 2007), leading to more accurate management forecasts as managers use more accurate financial inputs to form their forecasts (Feng et al., 2009), and improving investment decisions (Cheng et al., 2013) as well as firm operating efficiency and firm performance (Feng et al., 2015). These studies rely on the notion that the reports generated from a system with ineffective internal controls contain errors (often unintentional errors), and thus the information management uses to create financial statements and make decisions is faulty. There is limited evidence, however, on whether internal controls reduce managers rent extracting behavior. Skaife et al. (2013) provide some evidence that the profitability of insider trading is greater in firms with ineffective controls. They suggest that a weak internal 6 We use the term internal controls to refer to internal controls over financial reporting. 7

10 control environment provides managers with an information advantage, enabling them to profit from their private information by selling before stock price declines. They do not provide evidence, however, of the more direct rent-extraction we examine. In particular, although selling personal shares at a profit is evidence of opportunism, it is both more indirect and less costly to shareholders than the more egregious and direct evidence of corruption we examine. 7 This is especially salient given Skaife et al. (2013) find only limited evidence of managers managing earnings before selling their personal shares. The focus of our study is whether internal controls curb the extent of corporate corruption, which is an escalated form of managers rent extracting behavior that represents a much more direct and quantifiable cost to shareholders. The lack of evidence on the association between internal control strength and managers corrupt behavior is likely due to two reasons. First, strong and well-enforced investor protection in the U.S. constrains insiders ability to acquire private control benefits (Leuz et al., 2003; La Porta et al., 2000); as a result, U.S. firms likely exhibit significantly less corporate corruption, on average, than firms in countries with poor investor protection. Second, there is no strong pattern of, or evidence on, how insiders engage in corporate corruption in the U.S., making it difficult to measure corruption. Using a sample of Chinese firms allows us to overcome both of these limitations. First, China has particularly weak minority investor protection, in part because China s legal system lacks enforcement (Allen 7 As an example, the CFO of South Airline Co., Liming Chen, tunneled numerous loans from the company to related parties. For instance, he took a corporate loan of $30 million Chinese Yuan from China CITIC Bank, and then moved the money in the form of other accounts receivable to a company controlled by his friend, Zhuangwen Yao. To return the favor, Zhuangwen Yao, gave Chen a BMW car worth $700,000 Chinese Yuan and a house worth $2.25 million Chinese Yuan as gifts. In addition, Chen took bribes of over $53 million Chinese Yuan from various sources. 8

11 et al., 2005). Allen et al. (2005) show that even among seven developing countries, China s corruption index is ranked the worst. 8 As a result, corrupt behavior by controlling shareholders and managers is wide-spread (Jiang et al., 2010). Second, prior research provides evidence on common approaches through which controlling shareholders or managers expropriate minority shareholders in China (Jiang et al., 2010; Cai et al., 2011). Therefore, we are able to measure specific corporate corruption such as the tunneling of cash from the firm through inter-corporate loans, the payment of personal entertainment or consumption with firm resources, or the ex post revelation that managers accepted bribes (for example to contract with inferior suppliers) or embezzled from the firm. We predict that it is more difficult for managers and controlling shareholders to undertake corrupt activities in a stricter internal control environment. For example, the common technique of issuing loans to transfer cash (i.e., tunneling) would be curbed by the requirement of a loan approval process that spells out interest and repayment terms. Related controls would trigger personnel to follow up on expected interest/principal payments that have not been received. With respect to private consumption by management, it is possible that requiring separate personnel to approve versus pay for invoices (i.e., segregation of duties) would curb much of the inappropriate reimbursement of personal consumption expenses. In addition, beyond the establishment of segregation of duties, routine reviews of expense reports or maintaining a clear reimbursement policy would likely further reduce 8 These seven countries are: China, India, Pakistan, South Africa, Argentina, Brazil, and Mexico. The corruption index used in Allen et al. (2005) is based on the International Country Risk Guide s assessment of the corruption in government. Lower scores suggest that high government officials are likely to demand special payments and illegal payments are generally expected throughout lower levels of government in the form of bribes connected with import and export licenses, tax assessment, policy protection, etc. 9

12 corrupt behavior of charging for items used for personal reasons or simply faking receipts. As another example related to accepting bribes, stricter purchase order authorization would ensure that managers are not over-ordering or ordering at an unreasonable price. Although even in the presence of such internal controls, managers may simply override the controls, we state our first hypothesis as the following, in the alternative form. H1: Firms with stronger internal controls have less corporate corruption. Next we examine whether the relation between internal control strength and corporate corruption varies with whether the internal controls were more likely to be voluntarily adopted or policy-driven. To proxy for this construct, we examine the ownership structure of the firm. Specifically, we investigate whether state ownership in China influences the effectiveness of internal control in curbing corporate corruption. As of 2010, sixty-five percent of listed firms in China were state-owned enterprises, accounting for 89 percent of total market capitalization in China (Piotroski et al., 2014). The government is the controlling shareholder of stated-owned enterprises and appoints key executives such as the CEO and the chairman of the board. As a result, the top managers of stated-owned enterprises have multiple objectives. In addition to profit maximization, they might also be working to improve employment rates or build relationships with government superiors; these other objectives could cause significant inefficiencies for the firm (see Piotroski and Wong, 2012; Piotroski et al., 2014). Following the implementation of the Sarbanes Oxley Act in the U.S., the Chinese government began to emphasize improving publicly listed firms internal controls. In June 2005, the Ministry of Finance, China Securities Regulatory Commission (CSRC), and the 10

13 State-Owned Assets Supervision and Administration Commission (SOASAC) jointly issued the Report on Learning from Sarbanes Oxley to Strengthen Our Listed Firms Internal Controls. In the Fourth Plenary Meeting of the Tenth People s Congress on March 5, 2006, Premier Jiabao Wen stated that we need to introduce and learn from other countries experiences in corporate governance, standardize governance mechanisms, and improve internal control systems. A series of governmental guidelines were issued following Premier Wen s address. The central government wanted to establish role models of state-owned enterprises to benefit the social goals of the government. The guidelines issued by SOASAC state that central government-controlled enterprises should develop internal control systems and prevent corruption. Moreover, the Basic Standards for Large and Median SOE on Developing Modern Enterprises System and Strengthening Corporate Governance issued by the General Office of the State Council of PRC states that: Those state-owned enterprises classified as major enterprises by the central and local governments, are required to identify deficiencies according to the Standards and make improvements to comply with the Standards. All other enterprises should also follow the Standards and strive to meet all the requirements. The committee on trade and economy, and the budget committee at the central government and local governments are called to conduct research and investigation on the effectiveness in implementing the standards. Clearly, state-owned enterprises are under pressure from the government to establish certain types of internal control procedures, which is compounded by managers of the stated-owned enterprises (current or former government bureaucrats) having incentives to maintain strong political connections with government officials. The concern, then, is that state-owned firms will adopt in name a boilerplate list of internal control procedures simply to satisfy government regulators and not actually 11

14 implement or enforce these internal control procedures. As a result, such policy-determined burdens (e.g., certain types of internal controls) are not necessarily effective in achieving the stated goal of reducing corporate corruption. As suggested in Lin et al. (1998), policy burdens reduce the efficiency of state-owned enterprises operations. In addition, as argued in Piotroski and Wong (2012), greater state involvement in an economy creates incentives for financial reporting opacity to hide the rent-seeking activities of politicians and related parties. This means that, although management of state-owned enterprises have incentives to adopt strong internal controls on paper, they likely have fewer incentives to actually realize the benefits of these internal control practices, relative to firms that voluntarily choose to establish strong controls. Because they have the power to override or simply ignore internal controls in place, the most corrupt managers are unlikely to be restrained by internal controls. As an example, Yunnan Copper Co. is a state-controlled enterprise with a market capitalization of 14 billion Chinese Yuan. In 2007, it was disclosed that the CEO, Zhaolu Zhou, abused his right in deciding whom to give contracts to and took at least 19 million Chinese Yuan in bribes. In Zhou s self-reflection report that he wrote during the detention period, he acknowledged that he had too much power and was able to override the internal control systems within the firm. 9 We thus hypothesize that policy-driven changes in internal control guidelines and procedures are less effective in reducing corporate corruption: H2: Strong internal controls are less effective at curbing corporate corruption when they are policy-driven relative to when they are voluntarily adopted. 9 Bureaucratic prisoners in China are required to write self-reflection reports detailing their transgressions and the motivations for their actions. 12

15 We use the adoption of internal controls within state-owned enterprises to proxy for policydriven adoptions. 3. Data, sample selection, and measures for corporate corruption 3.1. Internal control index and sample selection Our ICFR measure is based on the underlying data used in Chen et al. (2013). These data cover 99% of all Chinese listed firms from 2007 to 2010 and indicate whether 144 specific firm features exist within each firm. These 144 firm features each fall within the five main aspects of internal control proposed by COSO: (1) Control Environment, (2) Risk Assessment, (3) Control Activities, (4) Information and Communication, and (5) Monitoring (see Appendix A). 10 As our focus is ICFR, we focus on the existence of 69 of the 144 firm features collected for the initial index (see Appendix B). Each of the 69 items receives a score of one if it is in existence, which we then average within each control aspect (three-digit level in Chen et al. 2013). Finally we aggregate the scores from each control aspect and calculate the average ICFR score ranging from zero to one. See Appendix B for a more detailed description of the calculation of our ICFR score. Our sample begins with all Chinese firms listed on the Shanghai and Shenzhen stock exchanges that have internal control index data from 2007 through We present the 10 These data were collected developed by the research team led by Hanwen Chen, supported by China NSF grant # , and Ministry of Education Social Science Major Research grant #10JJD Since its creation, the index has gained recognition from researchers, practitioners and regulators as the metric of Chinese firms internal control effectiveness. These data are considered the most comprehensive and authoritative detail on internal control by Chinese regulators and security market participants. For example, on June 11, 2010, all three of the most authoritative Chinese financial newspapers, the China Securities Journal, Shanghai Securities News, and Securities Times, featured articles introducing the index. The researchers who developed the internal control index annually publish the top 100 firms that have the highest internal control scores in the China Securities Journal. Deloitte highlighted this index on the website of its Corporate Governance Center; and the Public Company Monitoring Division of the Shanghai Stock Exchange also acknowledged that the index has significant reference values for our efforts of monitoring internal control and corporate governance. 13

16 sample selection procedure in Table 1, Panel A. We remove 120 firm-years in the financial industry as financial firms are under different internal control requirements issued by the People s Bank of China and the China Securities Regulatory Commission. We then delete 1,401 firm-year observations that are traded on the small and medium-sized enterprises (SMEs) board because these firms are subject to different internal control and disclosure requirements. Of the remaining firms, 468 firm-years do not have necessary data for the analysis on the determinants of internal control, resulting in a sample of 4,775 firm-year observations. We obtain the information on firms stock prices, company financials, industry classification, ownership structure, auditors, and largest shareholders from the Chinese Stock Market and Accounting Research (CSMAR) database. As shown in in Panel B of Table 1, our sample is evenly distributed across our sample period, and about 67% of our sample firms are state-owned enterprises, i.e. the controlling shareholders are either the central or local government, or their agencies. [Table 1] 3.2 Measures for corporate corruption Our first measure of corporate corruption is intended to capture tunneling through the use of inter-corporate loans. Jiang et al. (2010) document that tunneling is a prevalent and persistent method used by controlling shareholders to expropriate funds from minority shareholders. Following their paper, we use other receivables scaled by total assets (TUNNEL) to measure the extent of tunneling. This measure captures one specific approach through which controlling shareholders or managers can expropriate funds for personal gain. Prior research has also shown that corporate executives in China often misuse the corporate funds for their private consumption such as dining, travel and entertainment. In China, entertainment providers generally are willing to provide any type of receipt that their 14

17 clients prefer to have for reimbursement purposes; thus extremely lax accounting regulations and enforcement allow the reimbursement of personal consumption expenses to be classified as business related administrative expenses. We manually collect the information from the notes to financial statements in the annual reports on the following expenditures: office supplies, business travel, entertainment, communication, training abroad, board meetings, automobile, conferences, and other expenses. Thus, our second proxy of corruption is the sum of these expenditures scaled by sales (PRIVATE) which is intended to capture private consumption (Cai et al., 2011). 11 Our third measure of corruption is the ex post detection and disclosure of corruption by either regulators or the media. We collect exposed corruption cases from both main stream Chinese media sources and litigation cases to ensure the most comprehensive coverage. 12 We require that this disclosure indicates self-serving behavior (e.g., embezzlement or the receipt of bribes) by management, and we set EXPOSED equal to one for the firm-years involved with the exposed corruption cases, and zero otherwise. 13 We analyze each corruption case to determine the timing of corrupt behavior (i.e., when the management undertake the corrupt behavior). One advantage of this measure (EXPOSED) is that we have a high level of 11 PRIVATE could also capture the expenditures used to bribe external parties to negotiate deals that benefit firm. It is likely that internal controls will not curb such bribing behavior as it benefits the firm; therefore, this might weaken the effect of internal control on PRIVATE. 12 To collect publicly disclosed corruption cases, we first search the China Economic News Database, which consists of articles published in all Chinese newspapers and periodicals. We use the following keywords to conduct the news search: corruption, Shuanggui (detained and interrogated), stepping down, economic issues, embezzlement, misappropriation, bribery, job suspension, favoritism, property transfer, and Xiake (stepping down). Next we searched within all legal case documents that are relevant to corruption from the courts in accordance with LawInfoChina (LawInfoChina is a data center for court legal documents). Finally, we used the Baidu search engine to retrieve public companies corruption materials based on company names identified from our search. 13 We do not include those corruption cases that involve giving bribes to external parties (e.g., government) for the firm s benefits (e.g., obtaining a contract with the government). Of the 159 cases involving exposed corruption, 120 relate to accepting bribes at the expense of shareholders (e.g., to buy inventory at above-market prices). The remaining cases involve various embezzlement actions. Because some corruption cases involve multiple years, we have 214 observations with EXPOSED = 1. To minimize the effect of Type II errors on our analyses (i.e., undetected corruption cases contaminating our control sample), we remove firms that involve other types of CSRC regulation violations and qualified audit opinions from the control sample. 15

18 confidence regarding the existence of corrupt behavior (the type I error rate is low). These detected and exposed corruption cases tend to be egregious in nature. One disadvantage, however, is that many corruption cases likely remain unidentified (the type II error rate is high) and there could be selection biases in the exposed cases. In contrast, it is likely that our two other measures (TUNNEL and PRIVATE) have higher type I error rates, but lower type II error rates. Thus, it is important to consider evidence from all three of our corruption measures. We report descriptive statistics of the main variables in Panel A of Table 2. In our sample, the mean (median) of ICFR score is (0.448). The mean (median) of tunneling (measured by other receivables) is 2.7% (1.2%) of total assets, where the mean (median) of total assets is 6,966 (2,504) million Chinese Yuan. The mean (median) of PRIVATE is 2.7% (1.0%), where the mean (median) of sales revenue is 4,935 (1,444) million Chinese Yuan. During our sample period, on average 4.5% of sample firms are detected and exposed for corruption such as accepting bribes or embezzling assets. [Table 2, Panel A] We report descriptive statistics by state-owned enterprises (SOEs) and non-soes in Panel B of Table 2. Consistent with the push by the government to establish internal control procedures within SOEs, the ICFR scores are higher for SOEs than non-soes at both the mean and median. For example, the mean score for SOEs is versus for non-soes. With respect to our three corruption measures, tunneling and reimbursement of personal consumption expenses appear more pervasive among non-soes whereas there are notably more instances of publicly disclosed corporation within SOEs, with the mean value of 16

19 EXPOSED equal to for SOEs compared to a mean value of for non-soes. Thus, there is some evidence that managers of SOEs are more likely to accept bribes, relative to managers of non-soes, who are more likely to extract funds via loans they do not expect to repay or through questionable expense reimbursements. SOEs are generally larger than non-soes, but are slightly less profitable, consistent with these firms and managers having more objectives than solely profit maximization. Finally, the Big4 audit firms have a much larger presence within SOEs, although the vast majority of firms are audited by smaller audit firms, consistent with prior research (e.g., Chen et al., 2011). Turning to the correlation table in Panel C of Table 3, we find that ICFR is negatively correlated with TUNNEL and PRIVATE (consistent with H1), but not EXPOSED. From the low correlations of our three corruption variables, it is clear that each captures a distinct component of corruption. [Table 2, Panel B] 4. Research design and empirical results In this section, we first perform tests to validate our measure of ICFR strength in Section 4.1. We present our main analyses examining the relation between internal controls and corporate corruption in Section 4.2. We follow our main analysis with a discussion of potential endogeneity concerns and present results using a two-stage design in Section 4.3. Finally, we discuss our robustness tests in Section Internal control strength and earnings quality As a validity test of our internal control measure, we first examine the association between the internal control score (hereafter ICFR) and earnings quality. To the extent that 17

20 our measure of internal control strength captures the strength of internal control, we expect to observe a positive association between ICFR and earnings quality. We examine two measures of earnings quality: the absolute value of discretionary accruals (ABSDA) and the occurrence of accounting errors (RESTATE). Earnings Quality = β 0 +β 1 ICFR +β 2 CFO +β 3 LEV +β 4 ROA +β 5 MB +β 6 EISSUE +β 7 DISSUE +β 8 BIG4 +β 9 TOP1SHR+ ε (1) The dependent variable is ABSDA or RESTATE. ABSDA is the absolute value of the residuals from the performance-adjusted cross-sectional modified Jones model (Kothari et al., 2005). RESTATE, equals one if the firm subsequently restated an accounting error made in the current year, and zero otherwise. We control for variables documented in prior literature that influence the magnitude of discretionary accruals including cash flows from operations (CFO), leverage (LEV), firm accounting performance measured by returns on assets (ROA), and growth opportunities measured by market-to-book ratio (MB). We also control for new issuances of equity and debt (EISSUE and DISSUE) because firms have stronger incentives to manage earnings in the presence of financing needs (Dechow et al., 1996). We also include audit quality, which is an important factor in determining earnings quality; BIG4 is equal to one if the auditor is one of the four largest U.S. accounting firms, and zero otherwise. Lastly, we include the percentage of shares owned by the largest shareholder (TOP1SHR) to control for potential effects of ownership structure on accounting quality (Dechow et al., 1996). We again include year and industry fixed effects. We present the results in Table 3. We find that ICFR is negatively associated with both the absolute value of discretionary accruals (ABSDA) and the occurrence of accounting errors (RESTATE), suggesting that earnings quality is lower for firms with weaker internal 18

21 controls. The coefficients on the control variables are largely consistent with prior literature. Overall, the findings in Table 3 provide support for the validity of our internal control strength measure. 14 [Table 3] 4.2. Internal control and corporate corruption Internal control and tunneling We begin our testing of H1 and H2 with tunneling (TUNNEL) as our measure of corruption. Specifically, we estimate the following model: TUNNEL = β 0 +β 1 ICFR +β 2 ASSET +β 3 ROA +β 4 TOP1SHR +β 5 CEOCHAIR +β 6 INDIRECTOR +β 7 MARKETIZATION +β 8 BIG4 +β 9 EXCHANGE + ε (2) The dependent variable, TUNNEL, is other receivables scaled by total assets and is intended to identify the existence of tunneling (the receipt of cash loans that are not expected to be repaid). ICFR is a variable ranging from zero to one with a higher value indicating stronger internal controls over financial reporting (see Appendix B). H1 predicts that effective internal controls reduce the extent of corporate corruption; therefore, we expect the coefficient on ICFR to be negative. Following Jiang et al. (2010), we include firm size (ASSET), profitability (ROA), shares owned by the largest blockholder (TOP1SHR), and the development of the regional market in which the firm is registered (MARKETIZATION) as control variables. Jiang et al. (2010) show that tunneling decreases in firm size and firm profitability. They also show that tunneling decreases in the ownership of the controlling shareholder because a large ownership interest mitigates the controlling shareholder s incentives to extract private benefits that would destroy firm value. Tunneling is also expected to be more serious in a less developed regional market as less developed local markets are associated with weaker legal and regulatory environments. In addition to the 14 This is consistent with the findings in Chen et al. (2013) who examine the full internal control index, whereas we focus on ICFR. 19

22 controls included in Jiang et al. (2010), we include CEOCHAIR which equals one if the CEO is also the chairman of the board, because we expect more powerful CEOs to have more opportunities to misappropriate corporate funds. For this reason, we also control for the percentage of independent directors on the board (INDIRECTOR). In theory, the presence of independent directors would protect minority shareholders (or the firm s) interests and curb tunneling behavior. However, because independent directors in many Chinese firms (especially state-owned enterprises) have private connections with management or blockholders, they may collude in tunneling. Thus we have no prediction on INDIRECTOR. We include BIG4 to control differences in audit quality and EXCHANGE to control for different regulations and requirements under the two exchanges, although we do not have a directional prediction for this variable. Finally we include year and industry fixed effects in the regression. We report the regression results in Table 4. Consistent with H1, the coefficient on ICFR is significantly negative (coefficient = 0.014; p-value = 0.036), suggesting that stronger internal controls curb tunneling. The coefficients on the control variables are consistent with those in Jiang et al. (2010). Specifically, tunneling is decreasing in firm size (ASSETS), profitability (ROA), percentage of shares owned by the largest shareholder (TOP1SHR), and the degree of development of regional markets (MARKETIZATION). We do not find a significant association between tunneling and the CEO also being the Chairman, nor between tunneling and the big-four audit firms being the auditor. Next we examine H2 by estimating Equation (2) separately for SOEs and non-soes. We present the regression results in Columns (2) and (3) of Table 4. Interestingly, ICFR is no longer significant among SOEs (coefficient = 0.006; p-value = 0.212), but is a strong predictor of tunneling within non-soes (coefficient = 0.033; p-value = 0.023). The 20

23 coefficient on ICFR is statistically different between SOEs and non-soes (p-value = 0.066). 15 This result suggests that although internal control over financial reporting effectively mitigates tunneling within non-soes, this is not the case within SOEs. This result is consistent with our prediction (H2) that policy-driven adoptions of internal control are not as effective as adoptions that are more voluntary in nature, highlighting the importance of substance over form. In summary, the results using tunneling as a measure of corporate corruption are consistent with both H1 and H2. We find a negative association between internal control strength and the extent of controlling shareholders harming minority shareholders by extracting resources from the firm with inter-corporate loans. Within firms controlled by the government (SOEs), however, internal controls do not appear to curb this corrupt behavior. [Table 4] Internal control and private consumption The preceding analysis related to tunneling provides evidence on the effect of internal control on corporate corruption specific to inter-corporate loans. Corporate corruption, however, manifests in various ways. As discussed in Section 3.2, our next measure of corporate corruption is private consumption expense reimbursement (PRIVATE). Thus, we estimate the following model, where the dependent variable is PRIVATE. PRIVATE= β 0 +β 1 ICFR +β 2 PAYRATIO +β 3 MGMTSHR +β 4 ATO +β 5 ROA +β 6 EISSUE +β 7 DISSUE +β 8 BIG4 +β 9 TOP1SHR +β 10 CEOCHAIR +β 11 INDIRECTOR +β 12 MARKETIZATION (3) 15 To test whether the main coefficients are the same across different SOE types, we use the following Z- statistics: ; where b i and b j are coefficient estimates from the two sub-samples, and s 2 (b) is the squared standard errors of the coefficients (Clogg et al., 1995, Chen et al., 2010). 21

24 PRIVATE is the sum of expenditures for office supplies, business travel, entertainment, communication, training abroad, board meetings, automobile, conferences, and other expenses scaled by sales. We predict a negative coefficient on ICFR because stronger internal controls should limit the magnitude of private benefits resulting from the corruption. We include several control variables from prior research. First, executives with lower pay have stronger incentives to misappropriate corporate funds and assets for private consumption. Chen et al. (2005) find that executives substitute lower pay with excessive perquisite consumptions. We follow their measures of executive compensation and control for the ratio of executive total compensation relative to other employees average compensation (PAYRATIO). We also control for management ownership (MGMTSHR), measured as outstanding shares owned by executives, because management ownership helps align managers objectives with shareholders interests and reduces incentives for excessive perquisite consumption. We next include asset turnover (ATO) as a control variable to control for the effect of operating efficiency on selling and general administrative expenses. We control for firm performance (ROA) but we do not have a clear prediction on this variable. On one hand, more profits provide more resources for corrupt executives; on the other hand, uncorrupt managers might generate better performance (e.g., they will buy the best-value inventory). We control for new issuances of equity (EISSUE) and debt (DISSUE) since the expenditures included in our PRIVATE measure may increase during financing activities. Lastly we control for BIG4, TOP1SHR, CEOCHAIR, INDIRECTOR, and MARKETIZATION as in the tunneling analysis. 22

25 Table 5 presents the regression results for PRIVATE, our proxy for private consumption expense reimbursement. We find a significant negative association between ICFR and PRIVATE for the full sample (coefficient = 0.026; p-value = 0.039), suggesting ICFR effectively reduces corruption related to private consumption, again supporting H1. We again find that ICFR is insignificant within SOEs (coefficient = 0.001; p-value = 0.479), but is a strong predictor of corruption within non-soes (coefficient = 0.099; p-value = 0.007). The coefficient on ICFR within non-soes is statistically and economically larger in magnitude than the coefficient on ICFR within SOEs, in support of H2. [Table 5] Internal control and exposure of corrupt behavior Our third measure of corporate corruption is disclosed corruption cases (EXPOSED). We estimate the following model, where the dependent variable is EXPOSED: EXPOSED= β 0 +β 1 ICFR +β 2 PAYRATIO +β 3 MGMTSHR +β 4 SALES +β 5 ROA +β 6 EISSUE +β 7 DISSUE +β 8 BIG4 +β 9 TOP1SHR +β 10 CEOCHAIR +β 11 INDIRECTOR +β 12 MARKETIZATION + ε (4) EXPOSED equal to one if we identify an exposed case of corrupt self-dealing (e.g., embezzlement or the receipt of bribes to conduct suboptimal transactions) from either main stream Chinese media sources or litigation cases. In addition to the corruption determinants included previously, we also include SALES as a control variable because a majority of the exposed cases (120 out of 159 cases) relate to accepting bribes (e.g., to buy inventory at above-market prices). CEOs of firms with larger sales might have more opportunities to conduct this type of corruption (e.g., more suppliers will vie for the opportunity to bribe these managers as the gain is larger). We predict a negative coefficient on ICFR if stronger internal controls limit the opportunity for corporate corruption. 23

26 We provide the regression results for Equation (4) in Table 6. The association between ICFR and EXPOSED is insignificant for the full sample and the SOE sample, but significantly negative for the non-soe sample. This is consistent with our results on tunneling and private consumption in that internal controls appear to be effective at reducing corruption within firms owned and controlled by entrepreneurs and private investors, but not within state-owned enterprises. We find a significant negative association for the level of executive pay relative to other employees (PAYRATIO) within the full, SOE and non-soe samples, suggesting that a lower relative executive pay creates incentives for managers to accept bribes or embezzlement. We also find some evidence that powerful CEOs are more likely to accept bribes or embezzle within non-soes. We find that the percentage of independent directors (INDIRECTOR) is positively associated with EXPOSED within the full and SOE samples, but negatively associated with EXPOSED within non-seos. One possible explanation is that CEOs of state-owned firms appoint their friends to be independent directors, which would compromise the independence of the board. [Table 6] Taken together, our results from Tables 4 6 provide evidence that the strength of internal controls over financial reporting curb corporate corruption (H1). Internal controls within state-owned enterprises, however, are much less effective at curbing corruption, consistent with the importance of substance over form (H2) Endogeneity of internal controls In this section we discuss the potential endogeneity issue that arises because internal controls are not exogenous; instead managers and the board of directors choose to establish internal control policies and procedures. Managers with a tendency to misappropriate assets 24